Dominion Bond Rating Service says that 2005 was a positive year for corporate credit quality, highlighted by the fact that rating upgrades outnumbered downgrades for the first time in recent history.

“The story of 2005 must be footnoted, however, by the credit rating activity that took place in the North American auto sector,” says study author Anil Passi. “Isolating the effect of multiple downgrades to General Motors Corp, Ford Motor Co, and related entities, accentuates the positive credit activity across most of the rest of the economy. It also helps explain how much of the strength was mitigated because of the magnitude of deterioration, size, and significance of the North American auto companies in the debt capital markets.”

DBRS notes that the strong performance of 2005 was the continuation of an improving trend in the ratio of upgrades and downgrades that began in 2003 along with strengthening economies. Although it seems credit performance was at the bottom of a cycle in 2001-2002, it took until 2005 before upgrade activity actually exceeded downgrades, it notes.

The study also concludes that upgrade activity was fairly widespread across industries as strong economic conditions benefited most sectors. “The recent era of low inflation and interest rates has enabled capital investment to generate strong economic returns and growth in employment, which has resulted in high growth in consumer spending and asset appreciation,” it says. “These circumstances, in addition to increasing demand from major developing economies such as China and India, have benefited corporate earnings and credit quality in industrials, resource/commodities, energy, consumer, retail, real estate, and financial services over the past few years and 2005 in particular.”

Positive rating actions were fairly widespread across sectors, whereas downgrade activity was concentrated in North American automotive, telecommunications, paper/pulp/packaging, and a few one-off retailers and consumer companies. There was one default in the DBRS universe in 2005, and that was Hollinger Inc.

The rating agency says that it expects 2006 will be a year of stabilization for some of the strengthening credits, “as recently strong rates of earnings growth should abate somewhat and companies focus on increasing distributions to shareholders by dividends and/or share buybacks as opposed to debt reduction.”

DBRS says its major concern in 2006 is a sharp economic slowdown caused by inflationary pressure resulting from continued increases in commodity prices, possibly in combination with rising interest rates, which in turn would affect consumer strength via employment and asset valuations.

In terms of corporate management, DBRS would be concerned with an over emphasis on return to shareholders, or financially aggressive expansion plans in this type of environment. “Such an outlook may temper the recent positive trend for rating activity; however, it should not have a negative impact on credit profiles going forward as corporations have used improved earnings and cash flow of the past few years to strengthen their financial profiles (balance sheets) as well as replenish capital assets,” says Passi. “Therefore, DBRS expects a shift towards more balanced rating actions (stabilizing), coming as the result of both less upgrade as well as less downgrade activity in the coming year.”